Published online 10-04-05

Take a good look at your real estate assets. Do you see the tax savings that surround you? If you’ve handled your depreciation like most retail developers and building owners, I’m fairly certain that the savings are right there in front of you.

While depreciation may not be the most exciting topic you’ll encounter today, changing the way you approach it could give you a significant bottom-line boost.

Depreciation is one of the most widely misunderstood corners of accounting, and many developers and building owners fail to approach it in the most advantageous way. They’ll depreciate the total value of their buildings and personal property over 39 years, just like they’ve heard they should. Unfortunately, what they heard wasn’t necessarily correct. In many cases, as much as 40 percent of what they are depreciating is really personal property that qualifies for accelerated depreciation.

Developers and owners typically overlook the large amount of personal property and land improvements that are part of their investment in facilities. Most will capitalize items such as carpeting, vinyl composition tile, paving, electrical service for point-of-sale equipment, landscaping, dock equipment and retail fixtures. They treat those items as real property, depreciating them over a 39-year life.

But in most cases, all of those items should instead be classified as personal property or land improvements. Why is that important? Personal property is depreciated over a matter of years, rather than decades. Most personal property within retail centers qualifies for 5-year depreciation, while land improvements can be depreciated over 15 years. By expensing more depreciation now, you’ll reduce your taxable income, cut your tax burden and strengthen your current cash flow.

On average, owners can gain a net present value of $200,000 of additional cash flow for every $1 million of 39-year property that can be reclassified as personal property — and between 15 and 40 percent of most property typically falls into that category! (Of course, the actual amount depends on the specifics of the situation.)

The secret is an accounting concept called cost segregation. It’s nothing new, and it’s perfectly legal. Although most accountants have known about it for some time, few take the time to pursue it, because the IRS demands appropriate documentation to verify that costs have been properly segregated. Few accountants have the specialized knowledge to comply.

To obtain claims that stand up to IRS scrutiny, specialists perform what’s known as a cost segregation study. This typically involves specially trained construction engineers who use an engineering-based approach to identify property and building components that qualify for accelerated depreciation.

The specialists will examine architectural and engineering drawings, and may conduct a site visit to develop a firsthand understanding of how every foot of space is used. They’ll review contractors’ payments, change orders, and the owners’ costs and disbursements. The engineers then use construction industry standards to allocate and segregate material components, direct labor and indirect costs, separating those that are eligible for accelerated depreciation from those that should be deducted using the standard 39-year approach.

To grasp the opportunity in practical terms, consider this example, which involved a series of strip malls and retail buildings. The properties had been constructed at a total cost of approximately $8 million over an 8-year period, and no cost segregation studies had been performed. An engineering-based cost segregation study identified more than $2.1 million in assets that were actually eligible for accelerated depreciation but that had not been claimed. Taking that depreciation generated cumulative after-tax net present value savings of nearly $500,000, along with a cash flow savings of more than $670,000 for the first 5 tax years after the study.

Another reason cost segregation is important to developers and owners of shopping centers and other retail properties is the need for constant renovation and upgrading of facilities to keep them desirable for both tenants and consumers. Many of those renovations and upgrades — including land improvements, signage, lighting and flooring — involve personal property, making them eligible for accelerated depreciation that can offset some of that investment. With retail developers and properties, under-depreciated land improvements tend to be the biggest source of savings.

Investors that purchase existing facilities may see a higher return on investment through the use of cost segregation studies. If an investor or investor group acquires a retail facility on which a cost segregation study has never been performed, the potential for additional tax savings and cash flow will add even more value to that investment. Cost segregation can apply to existing properties, new construction and recent acquisitions.

Is cost segregation viable for you? If the cost of the building involved (not including land) is at least $750,000; you’ve purchased, constructed or renovated property in the past 12 years; you plan to retain that property for several years; and you currently have taxable net income, you stand to benefit from cost segregation.

In addition to current-year tax savings, you can also recognize retroactive benefits in just 1 year without having to obtain IRS approval or filing amended returns.

If you intend to pursue a claim based on cost segregation, be aware that proper documentation is critical, because the IRS scrutinizes claims carefully. For example, the documentation generally includes asset classifications and descriptions, allocated related fees and services, and asset-segregation spreadsheets, as well as references to tax citations and court rulings that support the claims.

— David McGuire is director of Cost Segregation Services with Greenwood, Indiana-based Hull & Knarr LLP.

This has been a quick summary of a very complex tax law. Just as no two retail facilities have identical locations and situations, every cost segregation study is different. Ask the firm that prepares your taxes if they have experience with cost segregation claims. If not, have them recommend a firm with such experience so you can be assured that your depreciation will be correct and your cash flow may receive a substantial infusion.